Types of Annuities: A Must-Read for All Investors

Why do you need to know about Annuities?

The purpose of any long-term savings or investment is to create retirement income, liquidity, as well as a sizable inheritance for your loved ones. There are two rates that make up everyone’s retirement income stream later on and both are equally important -1) The Accumulation Rate – getting up the mountain and: 2) The Distribution Rate – getting back down safely. Knowing how the retirement income streams work and then how distribution rates work is the basis for understanding how to save money in the pre-retirement years.

There are two economic powers. The first economic power we all have to work with is the Fluctuating Rates of Return power which can be a good accumulator of money. The second economic power is Actuarial Science which can be a good distribution power. These powers were always meant to work together in proper balance.

If you don’t incorporate distribution power then, you are defaulting to the 3% to 4% retirement income rate problem. When you incorporate Actuarial Science along the way you put yourself on a path that can potentially provide higher retirement income rates from the assets you have built. The balancing between these economic powers is the key as having too much of either can make you less efficient. Then the power of actuarial science, through the death benefits and cash values of Annuities, whole life insurance and index universal life can interact with the fluctuating rate of return power of retirement assets to create the ability to take higher retirement income rates safely. We need to be working towards building the proper balance between these two powers on our way to retirement.

What is an annuity?

An annuity is a type of investment contract or policy issued by an insurance company that allows you to save money for retirement or any long-term investment goals. The money you pay in can be either a lump sum or a number of payments. These payments then earn fixed interest (usually much higher than CD) or also get invested in the stock market, generally tax-deferred, and after a period of time, provide you with a stream of income or lump sum back.

Types of Annuities

There are many types of annuities and, may be classified in several different categories. Here are some examples:

  • Single Premium or Flexible Premium Annuities

A single premium annuity is structured to allow only one contribution to the annuity contract. Subsequent contributions are not allowed with these types of annuities. If investor (annuity policy owner or contract owner) envisions making additional contributions into an annuity contract, the annuity policy owner should consider purchasing a flexible premium annuity. A flexible premium annuity allows additional contributions at any time from the policy owner. Immediate annuities by very nature will be considered single premium annuities.

  • Immediate or Deferred Annuities

An immediate annuity is a contract with an immediate payment or one with payments that begin within one year of the contract by the insurance companies. A deferred annuity is a future pay contract with payments by the insurance company to begin at some later date beyond the first annuity contract year.

  • Qualified or Non-qualified Annuities

The annuity may be funded with monies accumulated within employer-provided qualified retirement plans like 401(k), 403 (b), SEP, SIMPLE, Profit Sharing Plan, Defined Benefit Plan and IRAs. Because each of these plans is designed to meet regulatory qualifications in order to allow pre-tax investments and tax deferral on earnings, the plans are referred to as qualified plans.

If the money placed in the annuity has already been subject to income tax, like your personal money, the annuity is classified as a non-qualified annuity. The benefit of tax deferral in non-qualified annuities can be a great value for non-qualified money that does not enjoy tax deferral in the vehicle in which it is currently invested.

  • Fixed Annuity, Fixed Index Annuity, or Variable Annuity

Deferred annuities are classified by the method the insurance company uses to determine how interest in credited to the annuity contract. A fixed annuity is the simplest of deferred annuity. It generally offers the annuity owner a guaranteed interest rate for a certain period of time. Once the initial period ends, a new interest rate is established. The fact that fixed annuities have guaranteed principal and interest make them much like the Certificates of Deposit (CD) that banks sell.

Fixed Index annuities which became popular after 1990, are relatively new to the life insurance industry. An indexed annuity ties the earnings in the annuity contract to an outside security index. The most popular type of indexed annuity is one tied to the Standard and Poor’s (S&P) 500 index. This type of annuity is meant to assist clients who want more growth potential than a fixed annuity can offer but who may not be ready for the full risk of a stock market. Fixed index annuities have become very sophisticated in last few years but this kind annuity is difficult to understand and sometime tricky.

A variable annuity is a deferred annuity that allows the annuity buyer to participate in investment funds, such as stock and bond mutual funds. This kind of annuity carries all the risks of stock market volatility and very high expenses/charges. If you have heard “Annuity is Bad” then they are talking about this kind! The primary objective of an annuity contract is to pay the persons who receives the annuity payments during their lifetime, not to offer a death benefit after they pass away.

One of the most prevalent reasons individuals purchase annuity contracts is to accumulate funds for retirement and then, once retired, to manage distribution of those funds. The older a person gets, the greater the probability that he or she will need annuities as a financial vehicle either to accumulate tax-deferred dollars for the future or as a source of guaranteed income that provides unique financial security features during retirement.

The fixed deferred annuities that are inherently tax deferred are ideal to help accomplish this financial goal, because fixed deferred annuities offer flexibility in making contributions into them, and offer guaranteed interest rate without any stock market risk. Annuity rates are usually better than bank CDs and interest income from fixed annuity are tax deferred. Because fixed annuities are tax-deferred by law, investors or annuity holders can choose when to pay taxes on the interest earned inside the annuity. By waiting until the annuity reaches maturity, taxes are paid at the income tax rate that corresponds to an investor’s current income, which may be much lower than during the investor’s working years. Deferred fixed annuity is a long term, retirement savings vehicle and withdrawals made before an investor or account holders reaches age 59 ½ may require, in addition to taxes, a 10% penalty.

Wondering if a fixed or fixed index annuity is the tool you need to create an income stream that will last for the rest of your life? Call (877) 972-3262 or complete contact us to speak Neil Jesani, CFP. Investment and wealth creation are much harder than most people think or even understand. The founder of world’s largest hedge fund and 25th richest man in USA, Ray Dalio says to Bloomberg that “it is harder to win in stock market than competing in Olympics”. We have been helping more 3000 physicians, 1000 dentists, 3000 successful business owners and 600 independent pharmacy owners create most optimal asset allocation, reduce taxes and create sizable wealth for last 20 years. We don’t have magic wand but we know thing or two that works.

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